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07/15/2010

What We Talk About When We Talk About Quality Dividend Yield

How to formulate an effective equity investment strategy in today’s uncertain market will be the topic of an upcoming NYSSA Market Forecast seminar. Merrill Lynch’s Head of U.S. Quantitative Strategy, Savita Subramanian, who will be a featured speaker at the luncheon, maintains that companies with “high-quality” dividend yields are particularly prudent picks in this environment, and that quantitative screening can enable investors to distinguish the “good” dividend plays from the “bad.”

Among the factors her group screens for are companies that have also posted stable earnings growth over the last economic cycle and that exhibit lower dispersion in analysts’ estimated earnings. Another factor she views as key is top-line (gross revenues) growth. “While we have seen pretty significant recovery in bottom-line (net income) growth for S&P 500 companies over the last four to six quarters we have not seen the same type of recovery in the top line,” says Subramanian. “Over the last six quarters analysts have gotten more positive on earnings growth but not so much on sales. We are seeing a more pervasive fear of a real risk of a double dip recession scenario.” So companies that fall into the “high quality dividend” category are generally those that exhibit strong and stable revenue and earnings growth, not just earnings growth from cost cutting.

Subramanian also subscribes to the belief that the economy is entering a “new normal” stage which may favor higher quality stocks as a secular theme. “I do think we are in a bit of a shift in regimes,” she says, noting that the standard deviation of earnings growth in the S&P 500 is at its highest point in the last seven decades. “It is off the charts today if you look back to the 1940s,” says Subramanian. “In fact we are now seeing the widest swings from losses to gains in the history of our data.” At the same time, she notes, the era of falling cost of capital that began in the mid 1980s and that led to a systematic premium attached to risky assets over the last couple of decades is coming to a close. “Now what we will be seeing for the next two decades is a rising cost of capital,” she reports. “It is not a matter of whether or not the Fed will tighten but when. When it does and when interest rates show signs of increasing the great heyday for risky assets will be over. After all, one of the biggest drivers for performance of risky assets has been a low cost of capital.”

Subramanian explains this relationship: “During the era of a low cost of capital if you were generating a single digit percentage return on capital, you were still clearing your cost of capital. There may have been less discipline in deciding what projects to invest in, because the hurdle rate was unusually low. When the hurdle rate is too low because of low funding costs there are fewer checks and balances on projects that receive funding.”

In this environment it is harder and harder to find the “good dividend” yielders. “If you look to companies that offer safe and stable dividends they are more scarce than they were a couple of years ago because there are fears of a rising cost of debt. Fewer companies were meeting their screens over the last couple of years because expectations of a higher cost of debt and an economic slowdown both eroded management’s confidence in their ability to continue to meet their dividend obligations let alone grow their dividend.”

Ultimately, says Subramanian, a stock with a solid dividend is that of a company that has a safe, sustainable dividend determined by the ratio of free cash flow to dividend payout, debt ratios, and lower variability of earnings growth. She also prefers companies that have shown a steady track record of growing dividends because it suggests that dividend growth is a core focus of management.

She also cautions against falling into the “dividend yield trap”—where high dividend yield is a consequence of a fall in share price. “You have to ask, ‘is the high yield the result of dividends growing or price shrinking?’”

One final argument for seeking out quality dividend yielders is that while the supply of good dividend yielding companies is shrinking the demand for them is increasing. “Baby boomers who lost a significant proportion of their assets during 2008 are not necessarily looking for the next long-term growth story,” says Subramanian, “they are looking for income and dividend yield.”

–Susan Arterian Chang is a financial writer and content developer for the Capital Institute.